Larry Swedroe on research into whether our investment biases are genetically hardwired.
It’s been well-documented that, on average, retail investors are “dumb” money. For example, on average, the stocks they buy go on to underperform and the stocks they sell go on to outperform. Investors, sadly, even manage to underperform the very mutual funds in which they invest.
Research from the field of behavioral finance has provided explanations for these poor results. In short, they’re the product of a long list of investment “biases” exhibited by individual investors. Among these biases are: Investors lack portfolio diversification due to overconfidence and a preference for investing in familiar securities (a home-country bias); they tend to trade too much (overconfidence again); they are reluctant to realize their losses (it is too painful to admit mistakes); they extrapolate recent superior returns into the future (the hot-hands fallacy); and they have a preference for skewness and lottery-type investments (which is explained by prospect theory).
While studies have shown that individual investors, on average, exhibit investment biases, little research has been devoted to uncovering their origins and the differences in them across investors. This, in turn, raises two questions: Are investors genetically endowed with certain predispositions that manifest themselves as investment biases? Or, do investors exhibit biases as a result of parenting or individual-specific experiences or events?
Investment Biases And Genetics
Henrik Cronqvist and Stephan Siegel contribute to the literature on investment biases with their study, “The Genetics of Investment Biases,” which appeared in the August 2014 issue of the Journal of Financial Economics.
To answer these questions, they used a unique data set, the world’s largest twin registry, the Swedish Twin Registry, and then matched it with detailed data on twins’ investment behaviors. This enabled them to decompose differences across individuals into genetic versus environmental components.
The decomposition was based on an intuitive insight: “Identical twins share 100% of their genes, while the average proportion of shared genes is only 50% for fraternal twins. If identical twins exhibit more similarity with respect to these investment biases than do fraternal twins, then there is evidence that these behaviors are influenced, at least in part, by genetic factors.”
The authors’ database included more than 15,000 sets of twins. Following is a summary of their findings:
Cronqvist and Siegel concluded that their study provided the first direct evidence from real-world, nonexperimental data that persistent investment biases are to a significant extent determined by genetic endowments. It seems that, at least in some cases, we are predestined to make investment mistakes. However, all is not lost.
Genetics Isn’t The Sole Determining Factor
While they found that education level did not moderate the effects of genetics, they also found that among investors with work experience in finance, there was a significant reduction of the relative amount of genetic variation (this was consistent with practical experience in finance moderating genetic predispositions).
They also found that even genetically identical investors who grew up in the same family environment differ substantially in terms of their investment behaviors. Individual-specific environments, experiences or events must therefore play an important role in shaping individuals’ investment behaviors.
The “good” news for many investors is that, at least now when they make a mistake, they can blame in on their genes! But being aware of our own biases gives us the knowledge we need to help us avoid making behavioral errors.
Some ways to do that are to create a well-thought-out investment plan (including an investment policy statement); use only passively managed funds; and, like Odysseus, who knew he couldn’t resist the sirens’ call, tie yourself to the “mast” of a rebalancing table.
This commentary originally appeared February 21 on ETF.com
By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.
The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.
© 2017, The BAM ALLIANCE
Up markets can cause anxiety, too. BAM ALLIANCE member Stuart Vick Smith goes on-air with her tips for prudently making the most of recent gains, a rising market and record highs. The bottom line? Stick to your plan and take a long-term view.
By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.
The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.
© 2017, The BAM ALLIANCE
Larry Swedroe on how the dispersion of returns among foreign and U.S. equities affects diversification.
Jan 25th, 2017
I previously examined a recent study that offered investors powerful evidence regarding a reduction, though not the elimination, of geographic diversification benefits in a flattening world. To more fully understand the integration of global equity markets, I then explored the correlation of returns between international and domestic stocks. Today I’ll resume my analysis with a look at the dispersion of returns among foreign and U.S. equities.
Dispersion Of Returns
In 2009, we saw very wide dispersion of returns. For example, while the S&P 500 was up almost 27%, the MSCI Emerging Markets Index rose 79%. And emerging market small and value stocks produced even higher returns. In addition, international large value and small value stocks, as well as international REITs, outperformed their domestic counterparts by wide margins.
Note the correlations were positive, as all equity asset classes produced above-average returns. However, the world didn’t look very flat in 2009.
In 2010, even though the S&P 500 returned about 15%, emerging markets stocks outperformed it by about 4 percentage points. On the other hand, U.S. large, large value, small, small value and REIT funds outperformed their foreign counterparts by significant margins.
In 2011, while the S&P 500 returned just greater than 2%, in general, international stocks provided negative returns. The MSCI Emerging Markets Index lost more than 18%.
In 2012, the relative performance of U.S. and international funds reversed; international funds outperformed their U.S. counterparts in all asset classes, although the return differences were relatively small.
In 2013, U.S. stocks outperformed international equities by wide a margin. For example, the S&P 500 Index, which returned 32.4%, outperformed the MSCI EAFE Index by about 10 percentage points and the MSCI Emerging Markets Index by approximately 35 percentage points. The world didn’t look very flat in 2013, either.
In 2014, domestic stocks generally not only far outperformed international stocks, but U.S. stocks rose and developed, non-U.S. markets generally fell. Again, the world didn’t look flat.
Integration Doesn’t Erase Diversification
In 2015, returns were all over the place. For instance, U.S. large stocks and developed, non-U.S. stocks produced similar returns, both close to zero. On the other hand, the MSCI EAFE Small Cap Index rose about 10%, while the MSCI EAFE Small Value Index rose roughly 5%. Their U.S. counterparts lost 4% and 5%, respectively. At the same time, the MSCI Emerging Markets Index lost almost 15%. Once again, the world didn’t look very flat.
Through Dec. 16, 2016, the world didn’t look all that flat either, with emerging market stocks underperforming developed market stocks. While Vanguard’s 500 Index Fund (VFINX) had returned 12.7%, the firm’s Emerging Markets Index Fund (VEIEX) returned 10.6%. DFA’s passively managed Emerging Markets Small Fund (DEMSX) returned a similar 10.4%, but its Emerging Markets Value Fund (DFEVX) returned 20.1%.
Once again, we see a wide dispersion of returns, showing the benefits of diversification even in a flatter world. (Full disclosure: My firm, Buckingham, recommends DFA funds in the construction of client portfolios.)
Hopefully, the evidence presented here demonstrates that, even though the benefits of a global equity allocation may have been reduced by market integration, they certainly have not disappeared. Thus, broad global diversification is still the prudent strategy. But there remains another important point we must cover.
The Death Of Diversification Has Been Greatly Exaggerated
Antti Ilmanen and Jared Kizer, in their 2012 paper, “The Death of Diversification Has Been Greatly Exaggerated,” which won a prestigious Journal of Portfolio Management award for best paper of the year, argues that factor diversification has been more effective at reducing portfolio volatility and market directionality than traditional asset class diversification. In other words, investors need to think differently about diversification.
In our new book, “Your Complete Guide to Factor-Based Investing,” my co-author, Andrew Berkin, and I make the case that investors can benefit from diversifying their portfolios across a small number (eight) of the more than 600 factors identified in the literature, a number so great that John Cochrane called it a “zoo of factors.”
We present evidence demonstrating that the market beta, size, value, momentum (both cross-sectional and times-series), profitability, quality, carry and term factors meet the criteria of being persistent across time and economic regimes; pervasive across sectors, countries, regions and asset classes; robust to various definitions; having intuitive risk-based or behavioral-based explanations for why we should believe they will continue to produce premiums; and are implementable (meaning they survive transaction costs).
In addition to each factor having earned significant premiums, they all have low-to-negative correlations to each other, which results in a portfolio with higher Sharpe ratios. The following table shows the annual correlations of the equity factors mentioned above during the period 1927 through 2015.
Note the low-to-negative correlations each factor has with the others, with the sole exception of the correlation between profitability and quality. The high correlation of these two should be expected, because one of the characteristics of quality is profitability. See Chart.
We also present evidence demonstrating that building a portfolio that diversifies across these factors greatly reduces the risk of producing negative outcomes.
The important message from the book is that investors can benefit from changing the way they consider diversification, moving away from the more traditional view of thinking only about diversifying across asset classes.
We believe investors are better served by thinking more broadly and looking at diversification across more unique sources of risk and return, which is really what factor-based investing is all about. And many of these factors, such as value, momentum, quality (also referred to as defensive) and carry, can be diversified across asset classes, bringing further diversification benefits.
Summary
There is evidence that, due to the greater integration of markets, the benefits of traditional global diversification of equity risk have been reduced. However, by accessing other unique sources of risk called factors, and diversifying those unique sources across stock, bond, currency and even commodity asset classes, more efficient portfolios can be created—ones with the important benefit of having less downside risk.
This commentary originally appeared January 6 on ETF.com
By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.
The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.
© 2017, The BAM ALLIANCE